The Practical Tech Lawyer: Two Places a Start-up Shouldn't Skimp on Documentation
Here’s a story you might have heard before. Fantastic Start-up, Inc. built a nice little business, from two founders and no revenue to 37 employees, 20 paying customers and revenue of $3.8 million last year. It took four long, hard years to get here, but now a VC firm wants to invest, and Fantastic Start-up could do some good things with that money. Due diligence started last week. And it doesn’t seem to be going all that well.
For some reason, the accountants they sent over keep asking about the company’s stock option program. They want to see board minutes, valuation reports, copies of the option agreements themselves, even offer letters. Offer letters? What’s going on here?
Fantastic Start-up might have some unhappy news coming its way.
Founders of technology companies are usually wonderful technology people; they can be brilliant marketers, too, and sometimes really good with people. But they don’t always understand the finer points of finance. Or administration. Or taxes. Or securities.
They will learn these things, sure enough. Smart people don’t have any trouble absorbing and retaining legal rules. But if you’re an entrepreneur and it’s your first rodeo, learn the ropes or learn from painful experience.
Problem Area No. 1: Stock Option Disarray
I’ve seen it in real life -- a technology start-up learns about expensive tax and securities problems during an investor’s due diligence examination. It’s embarrassing. It can reduce the company’s valuation. It can even kill the deal. If you have a young company that offers equity to employees, one of the most cost-effective things you can do is to bring your stock option or restricted stock program into compliance. It’s quite easy and inexpensive to set things up the right way at the beginning. But with each new grant, it becomes harder and harder to straighten out problems.
Documentation is the easy part. Your law firm can provide you with a package of unified documents, including:
- A stock incentive planBoard and shareholder resolutions for approving the plan
- A template for incentive stock option agreements
- A template for non-qualified stock option agreements
- A template for restricted stock agreements
- Template agreements for phantom stock and stock appreciation rights, if desired
- A plan description document (if total grants are over $5 million in one year)A form for making 83(b) elections with the IRS
- Wording for option awards in employment offer letters
Don’t try to make this stuff up on your own, or retro-fit a form you found with a Google search. If the law firm you use has any business practicing in this area, they can provide you with a plan, resolutions and templates that are fully integrated and legally compliant, all more or less off-the-shelf.
Follow the legal formalities. Before making any awards (including informal promises), take these legal steps:
- Have your board of directors approve the plan
- Have your shareholders approve the plan; although the federal tax code allows approval within the next 12 months, I recommend prompt approval
- Determine whether state “Blue Sky” filings are required. In Massachusetts, they are not; in other states (e.g., CA), they could be
- Create a system for tracking grants. Excel spreadsheets can do it, but specialized software is better, and usually priced cheaply for small private companies. (It’s a loss leader for the vendor, and they’ll jack up your license fees when you get bigger or go public.)
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